By Fraser Sherman Updated January 31, 2019
When you buy cars, computers or buildings for your business, they count as assets on your financial statements. If you lease them, the accounting is more complicated. If you use what's called a capital or finance lease, you report the leased property on your balance sheet as if it were an asset you own. If you have an operating lease, you record it as a liability.
Operating and Capital Leases
Operating leases are the kind of agreement most of us equate with the word "lease." For example, you contact a photocopier company and sign a deal to lease two or three for your office. The lessor still owns the machines, but in return for the monthly payment, you get to use them. If one of them breaks down after a couple of years, you lease a replacement. You never record the leased property as an asset.
Under a capital lease, you treat the property on your financial statements as though you bought it. This isn't optional; you have to treat the arrangement as a capital lease if it meets any of various conditions:
- The length of the lease covers at least three-quarters of the asset's useful life.
- You have an option to buy the asset at a below-market rate after the lease ends.
- When the lease ends, you assume ownership.
- The value of the minimum lease payments is 90 percent of the value of the asset when the lease begins.
Suppose you want to purchase $150,000 worth of construction equipment but you can't pay up front. You talk to a leasing company and work out a lease-to-own deal that will give you ownership of the equipment after two years of lease payments. This goes on the books as a capital lease.
The Balance Sheet
The balance sheet is a basic financial statement. The concept is a simple equation: On one side you enter your company's total assets, while on the other you add together your business liabilities and owners' equity. The two sides always balance out.
While simple in concept, federal regulations require you follow a very strict format. You have to know where to place every asset and liability on the sheet, including operating and capital leases.
Reporting the Leases
Let's say you took out a capital lease on a $1.5 million factory building for your business. To record the building on your balance sheet, you first calculate the value of the lease payments you'll be making. You treat this as the cost of the building. The $1.5 million goes down as a debit to your fixed assets on the balance sheet, and a credit under capital lease liability. Each time you make a payment, you reduce the capital lease liability. You also write off depreciation on the building, just as you would with one you purchased.
Before accounting standards changed in 2016, you didn't list operating leases on the balance sheet at all. The change requires that you now enter operating leases as a liability. You're also responsible for spotting and reporting hidden leases. If, say, you have a service agreement for IT services and it includes providing your office with computers, this might qualify as a lease under the new rules. If it does, it should show up on the balance sheet.
FAQs
If you use what's called a capital or finance lease, you report the leased property on your balance sheet as if it were an asset you own. If you have an operating lease, you record it as a liability.
Is a lease a liability on balance sheet? ›
Example of Lease Liabilities on a Balance Sheet
In the past, operating leases were unrecorded liabilities, and the only accounts that appeared on balance sheets for these were prepaid or deferred rent. But now all operating leases except for short-term leases must be capitalized on the balance sheet.
How do you record lease payments on a balance sheet? ›
The formula is quite simple – you just multiply the annual lease payment by the present value factor, and that results in the net present value of future minimum lease payments, which is recorded on the balance sheet as the lease liability (and ROU asset).
How do you account for lease payments? ›
Accounting for a finance lease has four steps:
- Record the present value of all lease payments as the cost of the lease.
- Record only the interest portion of each payment as an expense.
- Depreciate the recognised cost of the asset over its applicable life.
- Recognise the asset's disposal upon its retirement.
The lease liability is effectively treated as a financial liability which is measured at amortised cost, using the rate of interest implicit in the lease as the effective interest rate.
What type of liability is a lease? ›
A lease liability is the financial obligation for the payments required by a lease, discounted to present value. Under ASC 842, IFRS 16, and GASB 87, the finance lease liability is calculated as the present value of the lease payments remaining over the lease term.
Are leases recorded on the balance sheet? ›
GAAP rules govern accounting for operating leases. All leases 12 months and longer must be recognized on the balance sheet.
Are lease payments assets or liabilities? ›
If you use what's called a capital or finance lease, you report the leased property on your balance sheet as if it were an asset you own. If you have an operating lease, you record it as a liability.
Where are lease payments recorded? ›
at commencement of the lease term, the lessor should record a finance lease in the balance sheet as a receivable, at an amount equal to the net investment in the lease [IAS 17.36]
What is leasing in a balance sheet? ›
Leases are contracts in which the property/asset owner allows another party to use the property/asset in exchange for some consideration, usually money or other assets. The two most common types of leases in accounting are operating and finance (or capital) leases.
A lease will be recorded on the balance sheet as a right-of-use (ROU) asset and lease liability. The lease liability is the payment obligation over the term of the lease contract, while the ROU asset represents the control of the asset under the lease contract.
How do I categorize a lease payment in Quickbooks? ›
When you make a rent payment, make a debit entry to Lease Liability and credit cash. You need to make another entry to recognize the Lease Expense in a separate transaction with a debit to the expense account and a credit to Lease Liability and the Right-of-Use asset.
Are lease payments an expense? ›
Since the lessee does not assume the risk of ownership, the lease expense is treated as an operating expense in the income statement and the lease does not affect the balance sheet. In a capital lease, the lessee assumes some of the risks of ownership and enjoys some of the benefits.
Are lease liabilities included in total debt? ›
Operating leases are a form of “off balance sheet accounting” mechanism that allows a company to have a debt obligation that does NOT get disclosed on the company balance sheet. ... Lease payments (i.e., rent) are liabilities, which can be considered debt. But the lease itself can actually be an asset.
What are considered liabilities on a financial statement? ›
Liabilities are settled over time through the transfer of economic benefits including money, goods, or services. Recorded on the right side of the balance sheet, liabilities include loans, accounts payable, mortgages, deferred revenues, bonds, warranties, and accrued expenses. Liabilities can be contrasted with assets.
Does a lease count as debt? ›
Car leases or loans are liabilities, and your payments are included in monthly debt ratios. If you apply for a mortgage, student loan, or credit card while making car payments, you may qualify for a lower amount than if you didn't have them.
Is a car lease a liability or asset? ›
Because ownership of a leased car doesn't pass to you, it isn't your asset. Lease payments are, however, a monthly expense or liability. When you lease a car, your liabilities increase but your assets don't, so your net worth decreases.
How are leased assets treated in the balance sheet? ›
The lessor reports the lease as a leased asset on the balance sheet and individual lease payments as income on the income and cash flow statements. The lessee reports the lease as both an asset and a liability on the balance sheet due to their stake as a potential owner of the asset and their required payment.
